Why Stop Losses Can Be Risky - and an alternative solution to protect your crypto

A stop loss is an order placed on an exchange to sell an asset when it reaches a certain price. 

Although commonly used by traders (both long-buyers and short-sellers) to limit losses in case the market moves against them, stop losses also have downsides that are not always apparent. 

In this article, we will explore why stop losses may not always keep you safe, and introduce an innovative alternative method to protect your crypto from market crashes.

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Understanding Stop Losses

Stop losses are sell orders triggered when an asset drops below a predetermined level, and there are a few ways in which stop losses can be used (although they are not necessarily present on all platforms).

A basic stop loss, known as a stop-quote, sells the asset immediately, regardless of the price. However, if there is no buyer at that price on the order book, the execution price may decline even further, leading to the stop loss being executed at a less-than-desired price. 

The second type is the Stop Limit order, which triggers when a threshold price is reached. The danger here is that if there is no buyer, a sell order may occur at a price higher than the current market price, and the position may not be filled. However, imagine the market reverted at a future point, and the price of the asset went skyrocketing - if the user had placed a stop limit order which was not filled, and not cancelled either, it would sell the asset as price moves up after they’ve had to endure a period of time holding the “bag”. Ouch!

A trailing stop loss is another type of stop loss used when the market is going in the right direction - in other words, the market is heading up in the case of long sellers and vice-versa.

As the market continues to move up, the stop loss moves upward too, thus keeping a similar gap. The aim of using a trailing stop loss is to ensure that profits are locked in, and flash crashes and market reversals do not wipe out already earned gains.

However, a trailing stop loss can of course be triggered when a pull-back occurs before the price continues its journey further upwards, and this can mean users miss out on further gains that they would otherwise have made.

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The Risks of Using Stop Losses

One of the unintended side effects of using stop losses is that you will sell your crypto assets at a lower price than they are currently worth. Therefore, any expected return on the initial investment of the asset will always be lower than it is now. 

This is often exacerbated when stops are placed in a low liquidity market, as this can often lead to a significantly lower sale price than expected. 

Every time a stop loss is triggered, a trading fee is charged. Thus, setting stop losses frequently can reduce your capital as the fees add up. 

Moreover, stop loss orders are visible on the order book, and therefore these can be picked off by algorithmic high-frequency trading bots, effectively leading to parasitic slippage. This is where the term “stop loss hunting” comes from.

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An alternative solution to Stop Losses for crypto users

In contrast to how stop losses work, the Bumper protocol provides downside protection policies which do not limit potential upside gains. 

This is because, unlike a stop loss, the Bumper protocol does not automatically sell the asset if its price falls below a predetermined floor.

Instead, the price-protected asset remains locked in the Bumper protocol as a “liability” which could be fulfilled by one of two possible outcomes occurring at the expiry of the protection policy: 

1) If the assets price is equal to, or above the floor, the investor retains the asset and the opportunity to benefit from any further price increases. 

2) If the assets price is below the floor, the user leaves the asset in the Bumper protocol, and instead claims stablecoins to the value of the floor.

So, how does this work exactly? Well, Bumper is a two-sided risk market. On the one side are those who are taking protection, and on the other are users who are earning a yield by providing the stablecoins which are used to pay out under-the-floor claims. 

Effectively, these yield seekers are buying the risk of a downside price move from the protection seekers who pay a premium in return (which is automatically calculated and deducted when the protection position is closed).

Thus, Bumper allows crypto holders to enjoy greater flexibility and control over their investment decisions, without sacrificing downside protection, making it a versatile tool for risk management.

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The Bumper protocol launches in 2023, and you can find out more about it on the official website.